What follows is a rather simplified analogy but should help to explain our modern “fractional reserve” banking system…

Once upon a time, people used gold as currency. Gold does not corrode easily and as such is deemed to be a sensible way to represent and store value. The problem with gold though, is that it is not easily transported due to its weight and furthermore it is not easy to conceal large amounts of gold when travelling.

So, to lessen the risk of being robbed by outlaws and highwaymen, a goldsmith would take a deposit of gold from someone, who intended to travel from their own village to another, in exchange for a gold receipt. The traveller could then redeem their gold receipt for an equal amount of gold when they arrived at their destination from another goldsmith.

As long as the two goldsmiths had an arrangement to honour the receipts, then the traveller could travel more safely, as they could easily conceal a receipt for an amount of gold that would have been very difficult to hide. Of course, the goldsmiths would charge a small fee to the traveller for availing of this service. So far so good.

In bigger towns and cities people would avail of this service from goldsmiths when they didn’t intend to travel. They didn’t know all their neighbours and were reluctant to store a lot of gold in their homes, as occaisonally people’s homes were robbed. Instead they would store their gold at the goldsmith’s place of business as the goldsmith had greater security around the clock to store the much sought after gold.

Over time people started to buy things with the gold receipts rather than redeem the receipts for gold and buy things with gold. The person selling something could just as easily redeem the receipt for actual gold as the person making the purchase. This was essentially the birth of paper money.

Now here comes the “innovative” part. The goldsmiths began to realise that not everyone redeemed their gold receipts immediately. So, if they had some major expense such as buying a piece of land and didn’t have enough of their own funds to make the purchase, rather than borrow some gold from someone else and pay interest on their loan, they would write themselves a gold receipt. As long as they honoured that receipt by replenishing their gold reserves with real gold that they earned over time, the system would remain stable and intact.

The only danger was that everyone who had deposited gold would come to redeem their receipts all at once. But because people were now used to using receipts for trading as against using gold, this tended not to happen. So the goldsmiths were able to maintain a fraction of their gold reserves and nobody was any the wiser.

Over time, even more “innovation” took place. The goldsmiths started to decrease the the amount of real gold that they held in reserve and increase the amount of receipts. Furthermore, they started to lend receipts to other people who were short of funds to make their own purchases. This was the birth of fractional reserve banking.

Of course, the goldsmiths or bankers would charge a small fee or interest on the loan of the receipts, to the borrowers, to avail of this service. Lending receipts to other people was far more risky than issuing “fake” receipts to themselves. It was one thing to trust their own ability to pay back their own loans but quite another thing to trust someone else. So of course, they demanded some collateral for the loans from the borrowers, in the form of deeds to their land or homes. If the borrower was unable to pay back the loan for some reason, the banker could always repossess the land or home that was provided as collateral. The banker could then sell the land or house, most likely at a profit and the loan would effectively be paid back.

The real problem though was the matter of charging interest on the receipts. An example should help to illustrate. Let’s say that there are two bankers in a city who provide loans of gold receipts or money. They both agree to honour the receipts with gold when someone wants to redeem a receipt. The bankers figure out that they only need to keep a fraction of the actual amount of gold that they hold in reserve as not everyone will try to redeem their receipts at once. They work out that the ratio of gold to receipts is one to ten.

So, if Mr. Smith the goldsmith has 50 pounds of gold in reserve, he will issue 50 pounds in receipts initially to the depositor(s) of gold. But because the depositor(s) will not redeem the receipts immediately all at once, he lends out another 450 pounds in receipts to various borrowers. This brings the total amount of receipts that Mr. Smith has issued to 500 pounds of receipts.

Similarly, Ms. Banks has 50 pounds of gold on deposit for which she issues receipt(s), and lends out another 450 pounds of receipts bringing the total amount of receipts that she has issued to 500 pounds of receipts.

So the total amount of receipts issued now from both banks is 1000 pounds of receipts. Lets say that the loans issued had to be paid back within one year. As long as the borrowers all pay back their loans within that year and the original depositors don’t look for their gold back within that year, everything should be fine. There is 1000 pounds of receipts in circulation and the various borrowers should be able to earn enough receipts to pay back their loans.

However the problem is that both Mr. Smith and Ms. Banks have charged 10% interest on the loans that they issued. There are 900 pounds worth of loans, requiring that 990 pounds be paid back (900 pounds of principal plus 90 pounds of interest). Lets not forget, that there were also 100 pounds of deposits (between the two banks). So, by the end of the year, if the loans are to be paid back in full with interest and the depositors also redeem their gold deposits, 1090 pounds have to be returned to the banks. But there is only 1000 pounds in circulation so unless somebody mines another 90 pounds of gold some borrowers will have to default on their loans and thereby loose their collateral and have their homes or land re-possesed.

The modern banking system is far more complicated by the fact that money is no longer backed by gold and fractional reserve requirements are often lower than one to ten, of money on deposit to money loaned out. The musical chairs analogy is very appropriate. When the music stops playing or lending stops for some reason, somebody is going to end up without a chair to sit on. Somebody is going to loose their collateral in the form of their house or land. This is nothing to do with their trust worthiness, credit history or ability to earn money. It has nothing to do with a mortgage being 100% or more of the value of their house. There simply is not enough money in circulation to pay back all loans and the interest charged on them.